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About The Private Equity/ Venture Capital Industry

There is a lack of popular understanding on how a venture capital fund works and consequently
may not fully relate to how VC’s function.

PE/VC’s too play on Other People’s Money

To start with, it would help to understand similarities between PE/VC’s and entrepreneurs.
Just as entrepreneurs go through the cycles of opportunity, business plan, fund raising and
eventual exit through IPO or M&A, VC’s also follow a similar cycle. PE/VC’s identify the
opportunity space in which they want to play and then develop a business plan. The business
plan would broadly cover capital deployment strategies, time-frame for investing/exit, types
of opportunities that would be considered for investing as well as target returns at the fund
level. With this business plan, PE/VC’s approach a set of qualified investors for raising the
required funds for starting the PE/VC fund. This fund raising effort is an intense and time
consuming effort and closure can take anywhere from 12 months to 24 months depending on
the size of the fund, team, past track record, nature of opportunities etc. Just as PE/VC’s
perform due diligence on the opportunities, prospective investors who are considering
investing into the VC fund also perform detailed diligence on PE/VC’s.

Cash Flow Cycle Of Venture Capital/Private Equity Firms

In industry jargon, investors who contribute to the capital of the fund are called “Limited
Partners”(LP’s) and people who raise money and then invest in start-ups are called “ General
Partners” ( GP’s). Typically LP’s are high net worth individuals, family offices, pension funds
etc and contribute 99% of the fund corpus while GP’s contribute 1% of the fund corpus.
Investment into the fund by LP’s is generally based on a contribution agreement (Similar to
shareholders agreement). This agreement broadly lays down the roles of the parties,
governance and other requirements related to investments.
At this stage, it would be good to understand how PE/VC’s make money. General Partners/VC
firms receive their compensation in two forms. First they receive an annual management fee
that ranges from 2 % to 3% of the fund size for their operating expenses such as salaries, office
space etc.

Secondly, the GP’s receive a share of profits from the investments made by the fund ranging
from 20 % to 30%. However in most cases, GP’s receive their profit share only after repaying
the entire fund corpus along with a hurdle rate to their investors.

In most fund structures, annual management fee starts declining after year 4 or 5 and if GP’s
have not succeeded in raising their second fund by that time, they will not be getting any
management fees in subsequent years to support their ongoing expenses.

Just as there is a concept of vesting of stocks for founders, GP’s are also subject to a vesting
schedule with respect to their profit sharing. Generally speaking, PE/VC’s raise another fund
by the time they are in year 4 and the ability of the VC’s to raise another fund would largely
depend on the performance of their investments from the first fund or previous fund.

Life Cycle of A PE/VC Fund

As a generic model, VC’s assume 3 years as investment horizon during which they will source
deals and invest and next 4 years for developing their investments and positioning them for an
exit. Through selection of right investments, VC’s hope to generate superior risk adjusted
returns typically in excess of 30% at the aggregate fund level. In order to meet the target
return expectations, VC’s would have to naturally consider only those opportunities that
appear to have high growth and scale potential.
The PE/VC Firms Drip-Feed Investment Model

As can seen from above, generic structure of the VC funds and the mandate on which they
have been raised impacts how VC’s approach their investment. As entrepreneurs, VC’s need to
maximize the value creation and therefore would naturally be biased towards those
opportunities that have the potential of rapid growth/scale and exit. Because of these
parameters, in many cases, VC’s may turn down investing opportunities which otherwise are
profitable but may not rapidly scale from an exit perspective.

At this stage, it would be good talk about two key points of risk and scale. While the general
perception about VC’s being providers of pure risk capital is correct, one should realize that
VC’s risk taking is always in the context of risk, efforts and reward equation. Unless the
potential outcomes are large enough, VC’s are unlikely to support any idea stage opportunities
and would rather wait to see business developing traction before they could consider the same
seriously. This is very similar to what an entrepreneur would do in his own business. Scarce
capital or resources is always allocated to those projects or efforts that have a higher
probability of success.
Scale of the opportunity is another issue that is often difficult to qualify a priori. One useful
approach to scale would be to consider it from an exit perspective. Assuming that the exit
event is primarily in the form of an IPO, what would qualify as a good exit candidate?
Typically, a good IPO candidate is expected to have a market cap between 200 crores to 300
crores at the time of IPO . Depending on the nature of business, this could translate into
revenues of anywhere from 75 Crores to 150 crores at the time of going for an IPO. With this as
the background context, the scale question reduces to the ability of the business to hit
revenues of at least 75 Crores in 5 to 7 years time-frame from inception with reasonable
capital infusion. If a business does not have the potential to grow into this size, then it may
not be a good candidate for VC investing (technology or IP based exits are of different kind and
their valuation may not be based solely on revenues. Different metrics would apply to those
cases)

To sum-up, it is important to keep in mind that VC’s are also entrepreneurs with a clear
mandate to multiply money and create wealth. In order to achieve this, they take calculated
risks within the contours of their business plan/mandate and therefore would consider only
those opportunities that fit in with their requirements.

Comparison of VC/PE Models

Venture Capital Private Equity


Who are the  Pension funds Same as for venture e capital.
investors?  Insurance companies
 Family offices
 Sovereign wealth funds
 Endowment funds

Investment Investors come together as limited Same as for venture capital.


vehicle partners in a limited partnership ("LP"),
with the managers as directors,
members and/or employees of a
company or an LLP that contracts and
makes investment decisions on behalf
of the LP.

Target VC funds look to invest in early-stage or Traditionally, the PE business


companies start-up companies with the potential model has relied on the availability
for significant growth, commonly where of large amounts of debt – greater
revenues are not sufficient to support leverage means a smaller
working capital needs for planned proportion of own money is needed
growth. By investing their money at an to acquire the operating target,
early stage, where the operating and the ultimate returns to the
company's valuation is relatively low, PE fund will also be enhanced.
VC funds hope that their investment A PE-backed company must have
will grow rapidly and deliver a large sufficient cash flows to be able to
gain on the ultimate exit. support high levels of leverage.
As a result, most VC investments are Therefore, PE funds have almost
made in the technology or life sciences always looked to invest only in
sectors. mature operating companies with a
solid trading history, regular cash
flows and sufficient assets to
persuade a bank to lend.
To date, there has generally been
minimal focus among the PE funds
on the technology or life science
industries.
However, there are technology
companies already generating
good revenues that still offer room
for significant growth. They may
offer the potential for generating
returns that may not be available
from traditional PE industry sectors
in light of current limitations on
the availability of debt.

Transaction The VC fund invests directly in the On a buy-out, the PE fund will
structure target company. actually be acquiring the target
The transaction is a cash subscription company.
for preferred ordinary At the same time as negotiating
shares. The founders of an early-stage the investment documentation, the
company will PE fund will also be negotiating
typically hold ordinary shares in the acquisition documentation with the
company. It is unusual seller(s) of the target
to have any form of tiered holding company.
company investment A PE fund will set up a two or three
structure. tier structure of new
As the company will not usually be companies to be funded by debt
generating sufficient and equity. The bottom
revenues to support working capital company within either of these
needs, a VC structures will be used to
investment is likely to be one of a acquire the target company.
series of "funding Senior/mezzanine debt (bank debt)
rounds" to take the company through to is lent usually in the form
exit. of term loan agreements. The
Although there will usually be relevant financial institutions
significant overlap in the would usually request a full
investors at each funding round, the security package over the assets
investors and the of the target.
relative size of their investments may The PE fund would usually make
vary, with the result the majority of its investment
that an investor's percentage through loan notes, which will be
shareholding in a company subordinated to the bank debt.1
may be diluted (or may increase) over Equity will be in the new holding
time. company and the PE fund would
Debt is not a common feature of VC usually take ordinary shares
transactions. alongside the management team. A
PE fund investing expansion capital
into a VC-backed company is likely
to be doing so with the prospect of
an exiting the short or medium
term. However, depending on how
close the target company is to
generating profits, PE funds
will need to be aware that they
may be required to commit
additional capital to avoid dilution
of their percentage shareholding.

Level of VC transactions will usually be A PE fund acquiring an operating


control structured so that the company will almost
founders of the business retain, initially always require a majority
at least, a significant (sometimes the shareholding stake in that
majority) shareholding. company, so that it has
shareholder control. A PE fund will
often require "swamping rights", so
that it can act quickly in certain
default event situations (such as
breach of financial covenants or
warranties, any insolvency event or
any failure to pay to the fund any
preferential fixed dividend or loan
note interest) to take control and
remedy the relevant problem

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